The tech bubble is pumped, but not ready to burst

This article was taken from the June 2014 issue of Wired magazine. Be the first to read Wired's articles in print before they're posted online, and get your hands on loads of additional content by <span class="s1">subscribing online.

Ebulliophobia means a fear of bubbles. And it turns out that it's pretty widespread in the technology industry.

We've heard a lot about tech bubbles recently. The NASDAQ is currently sitting at a 13-year high, with tech stocks rising to levels not seen since the end of the dot-com era in March 2000.

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In February 2014 Facebook bought WhatsApp for $19bn (£11.4bn), making it the fourth biggest technology acquisition in history. While WhatsApp may have been the best in show thanks to its size, it is far from an isolated occurrence: $42.4bn (£25.2bn) worth of mergers and acquisitions were agreed in the first six weeks of 2014, a 14-year high, according to data from Thomson Reuters. So what's the problem?

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The most famous phrase used for thinking about bubbles is "irrational exuberance". The term was coined in December 1996 by Alan Greenspan, chairman of the Federal Reserve Board, who supposedly came up with it while soaking in the bath. It describes a market in which prices are sent hurtling upwards by the mass delusion of shared hunches from a large number of investors, pumped up by the hype.

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Its first public use was accompanied by a classic example of what Greenspan was talking about. Within hours of his uttering the words during a televised speech, stock markets around the world began to drop precipitously as investors began to react to the fact that they might be, well, the exuberant irrationalists in question.

Japan's Nikkei index fell 3.2 per cent; Hong Kong's Hang Seng plummeted 2.9 per cent; Germany's DAX and London's FTSE both fell four per cent, and the US's Dow Jones went down 2.3 per cent at the start of the next day's trading.

By claiming that we might now be in a tech bubble, the idea is that today's technology valuations defy logic, and that the industry is in for a sharp jolt back to Earth. But is this the case? While suggesting that this tech bubble is different is, of course, a dangerous thing, it's also a big mistake to assume that tech's current boom makes it an automatic repeat of the events of the late 90s. There's no doubting the enthusiasm in the air, but there are also some important differences to make note of. Could we be living in the age of rational exuberance?

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For a long time, economists were confused aboutwhere bubbles came from. A few years ago, a group of young scholars at Princeton University, New Jersey, were brought together to analyse the dynamics of bubbles and how they develop. They concluded that bubbles emerge at times when investors profoundly disagree about the significance of a big economic development -- such as was the case with the birth of the internet. Since it's tougher to bet on prices going down than up, bullish investors tend to dominate.

What is currently happening in tech does at first seem to conform to many of the broad descriptions of a bubble. As a result, it's all too easy to compare it to the events that led up to the 2000 dot-com crash. Nineties tech darling Netscape might be a very different business to WhatsApp, but the fact that both were valued at prices disproportionateto their revenue sure seems like a direct repeat. Netscape wasn't profitable when it went public -- although that wasn't enough to stop its shares rising from $12 to $120 (£7 to £70) within just three months of trading. WhatsApp, by comparison, has revenues of possibly hundreds of millions of dollars, based on a 470-million user base, but has been valued like a company that has yearly earnings of $1.5bn (£8.9bn). "We're clearly in a tech bubble," says Matthew Cowan, cofounder of tech investment firm Bridgescale Partners. "However today's bubble bears little resemblance to the bubble of 2000. Then we had a bubble where any bozo with a coherent plan was able to raise a substantial amount of money very quickly. Things were so extreme in that era that companies went public without any revenue, or sometimes even without a business model... It was a case of: 'Do you have your core management team, do you have some sexy investors, and can you tell a great story? Okay, you can go public.'"

That is no longer the case. Certainly there are hyped tech companies that will never actually turn a profit -- and some of these will be given huge valuations and snapped up by giants such as Google and Facebook, but that would seem to be the exception rather than the rule. "The last bubble was a valuation bubble, [in which] the companies did not have sustainable revenue," says Jason Calacanis, an entrepreneur and dot-com-era pioneer. "People are confusing that bubble with today's market."

The young startups prompting tech's fastest areas of growth today are a different proposition to the frivolous companies that defined the dot-com bubble. It's difficult, for instance, to think of a direct parallel for the infamous dot-com debacle of Pets.com: an ecommerce platform which sold ten-dollar bags of cat litter which cost $20 (£12) to deliver. The tech companies going public today may command hefty valuations, but they're much more established than their predecessors. In the decades leading up to the bursting of the last tech bubble, the average company backed by venture funding went public at around the four-year mark, with 80 per cent of them having annual revenues of less than $50 million (£30 million). Today, companies are going public around the nine- or ten-year mark, with much larger revenue streams.

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The same is true of the value of individual users. "Whether people thought Pets.com was a good idea or not didn't really matter because there just weren't enough people who were willing to buy on the internet," says Scott Kupor, partner and COO at venture capital firm Andreessen Horowitz. "There were around 55 million internet users back in 1998, versus 2.5 billion today. No matter how good those ideas were, the market opportunities were so small that they could never have been viable." "Back in the 90s, folks were not sure if they could trust the web, and frankly a lot of the services back then didn't provide massive value," says Calacanis. "Today, the internet is providing insane value to people. Need a car to pick you up in three minutes for 25 per cent less than a taxi? Sure! Can we find you a cool place to stay in Paris for half the cost of a hotel? OK! Need somewhere to store your files for a £1 a month that's 100 per cent reliable and fast? Nice!"

This prompts the question of whether there might be different types of boom periods. "People observe prices going up, and they decide that if prices go up a lot it must be a bubble," says Aswath Damodaran, professor of finance at the Stern School of Business at New York University, and one of the world's leading experts on tech valuation -- a man who correctly called both Apple's peak and Facebook's trough. "Statistically speaking, if prices go up a lot there's a greater chance you're in a bubble -- but there's no intellectual rigour behind the bubble argument if all that's behind it is the fact that social-media companies have doubled in price. A bubble requires something a little more substantial, and most of the people talking about bubbles don't seem to offer that substance."

At the heart of every bubble is a macro story that actually makes sense

The award-winning-Venezuelan economist and technology expert Carlota Perez has spent the last 40 years of her career looking at the interplay of technology and finance. "My first attempt was in the 70s trying to understand oil prices," she says. "I began looking at the impact of high-cost oil on technology. From there I discovered microelectronics and just thought, 'This is it: computers are going to replace oil, plastics and whatever else as our guide for innovation. They're going to change everything.'"

Perez approaches history as a series of technological revolutions. Each revolution not only introduces a set of new tools and industries, but also transforms the economy by opening up a new set of behaviours to us. The Industrial Revolution, for instance, introduced machinery for textile factories, but also created a kind of proto-internet in the form of a network of canals. Next came the age of steam, coal, iron and railways followed by the age of steel and heavy engineering which brought about transcontinental railways, steamboats and globalisation. The Ford Model T followed in 1908, and introduced the age of the car and of mass production; in 1971 Intel introduced its microprocessor, which kicked off the era of telecommunications and information technology.

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Each of these revolutions prompts several boom periods, which break down into what Perez calls the installation and deployment periods. The installation period lays down new infrastructures, challenges the old way of doing things, and creates new sets of winners. But it also promotes casino-like behaviour, and culminates in a bubble such as we saw with the 2000 dot-com crash.

After the collapse of the installation period comes a second boom that is less turbulent, longer lasting, and promotes a sharing of the wealth. Perez calls this the deployment period, and gives examples such as the boom of the Victorian era, or the sustained growth seen in the United States following the second world war.

What distinguishes this boom period is that it is not defined by just one technology, but by all industries working together in a convergent direction. With the infrastructure already laid -- and the technology now living up to its promise -- shared wealth can be enjoyed.

What connects the installation and deployment periodsis the technology that drives them. What differs is the approach. "At the heart of every bubble is a macro story that actually makes sense," says Damodaran. "In the dot-com bubble it was the idea that we were all going to be carrying out our activities online. And guess what?

That story was true. Even at the peak of the dot-com bubble, the market was getting the macro story right."

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The euphoria around the dot-com bubble and the recession that followed it are a perfect illustration of what is sometimes called Amara's law. Named after the engineer and futurist Roy Amara, Amara's law suggests that we overestimate the effect of a breakthrough technology in the short term, but underestimate its effect in the long term. "That's what we saw in the first dot-com boom, where there was a huge rush of money and funding, and then a massive hangover when the bubble burst in March 2000," says Michael Acton Smith, CEO of Mind Candy. "[At that point] nobody wanted anything to do with tech or internet companies for several years."

Today that trend has reversed. The only question, then, is whether it's the start of another short-term bubble, or the signal of a longer-term growth period. In other words, are we still in the installation phase, or have we entered the deployment phase? To Sonali De Rycker -- an investor active in the consumer internet and digital-media venture sectors -- it is the latter. "Big data, cloud computing and mobile represent three fundamental shifts in enterprise computing," she says. "It's taking place on billions of devices, rather than on millions. It's never happened on such a scale. It's unprecedented. The reason you're having acquisitions such as WhatsApp, the discussion around Snapchat, [and] the valuations of Twitter, is that you're seeing tectonic shifts, with people in the industry recognising what an important growth driver some of these assets could be."

One key difference with today's tech boom versus the bubble of 1999-2000, Perez argues, is that today we are playing the game of the giants. "Google, Facebook [and others] are looking out for anyone that could make them more competitive," she says. "After a bubble, there tends to be monopolies. The big companies have a lot of money, and they have to define the boundaries of the sector in a way that is advantageous to them. If there is a technology that could be disruptive to them, if bought by a rival, they will pay any amount to acquire it themselves."

For a company such as Facebook, a potentially disruptive startup such as WhatsApp will therefore attract a totally different value based less on short-term gain, than long-term strategy. The price might seem (and be) high, but there's a reason for it.

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Compared to the frenzy of the dot-com bubble this may be an example of rational exuberance, but it's still not without risk.

Several potential stumbling blocks need to be avoided -- both for companies wanting to live up to their sky-high valuations, and for the tech market as a whole to keep on growing. Being in the hands of a giant like Google or Facebook might offer greater security, but also at greater risk should they stumble. Unlikely as it might be, if either was to trip significantly it could have a "spooking the horses" effect on tech investment as a whole, causing investors to lose confidence. This could be the result of an unforeseen outside event, or else continued expansion in a way that crosses over into each other's territory. If Google and Twitter tell the same macro story -- and use this to justify exponential growth -- it could spell trouble. "I'm interested in winners and losers," says Domadoran. "The next time someone says that Twitter is worth $50 billion because it's going to have $100 billion in advertising revenue, stop them and ask, 'Well, if it's going to have $100 billion in ad revenue, then who's losing? Because it can't be coming from The New York Times, as most newspapers are penny change in this market. It's got to be coming from Facebook or Google. So if you have Twitter, Facebook and Google in your portfolio and you're telling me that each of these companies is going to be collecting enormous revenues, then I have a problem. Because you have all winners and no losers. It's not a zero-sum game; at some point for every winner there have to be some losers."

Another possible danger would be a return to the dot-com era, with smaller companies in competitive fields and no proven revenue streams, attempting to stage IPOs. "If some of those middling assets go public -- or if some of the existing younger companies start to disappoint -- the party [could be] ruined," De Rycker says. "The lesson to take from the [dot-com] bubble is that you can't have ten winners in each category," says Brent Hoberman, founder of Lastminute.com, which floated at the peak of the dot-com bubble in March 2000 and managed to survive its subsequent collapse. "That is really what made the bubble burst. There were companies such as eBay and Amazon, which, at the time the bubble burst, people argued were overvalued. In fact, they ended up being massively undervalued -- because they won in their categories by a massive margin. But the problem was the 50 other people who were valued as if they had a shot at being dominant in that space."

Perez takes a broader view. Tech companies, she says, are an "oasis" in an otherwise struggling economy. It's not so much that we're in a tech bubble, as tech itself is in a larger economic bubble -- and the way to truly push forward into the deployment period is not to worry about it bursting, but to support it in the same way that previous technological revolutions have been supported. This means longer-term investment and more support from governments. Only then will tech truly become the mass disruptor it can be.

Damodaran takes a philosophical view. For him, the billion-dollar question is not so much whether we're in a tech bubble, as whether being in a bubble is ultimately a bad thing for tech. "Bubbles are part of human existence," he says. "The way we change as human beings is that we overreach. If we didn't, we'd still be in caves, wondering if we shouldn't go to that far village because it might be dangerous. We dream things that we can't achieve. That's what creates bubbles -- the opportunities that people see at one point in time. Everyone aspires to it, and investors go along for the ride."

History shows that great technology can emerge at both high and low points in the market. The personal computer arrived just after the end of the post-war age of affluence, and the first mobile phone system appeared in 1982, which corresponds to the bottom of the stockmarket during that period. Market corrections might happen (although these are unlikely to be on the scale of the dot-com bubble), but the innovation boom will continue.

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And ultimately that's the one that really matters.

Luke Dormehl is a technology journalist and author.

He wrote about how your web presence will determine your next job in 05.14

This article was first published in the June 2014 issue of WIRED magazine